The Federal Energy Regulatory Commission recently proposed significant changes to its approach to calculating the return on equity (ROE) that may be included in cost-based transmission rates.
The Oct. 16 order (Docket No. EL-66) was issued in response to an April 2017 decision by the U.S. Court of Appeals for the D.C. Circuit that found FERC had not adequately explained its conclusion that the base ROE included in the rates of ISO New England (ISO-NE) transmission owners was unjust and unreasonable. In that decision, the appeals court also found that FERC had not adequately justified the replacement ROE it adopted for the ISO-NE transmission owners.
In response to the court’s rulings, FERC’s order proposed a new approach to determining, under Federal Power Act (FPA) section 206, whether an existing ROE remains just and reasonable. The decision also puts forth major changes to FERC’s framework for calculating a new just and reasonable ROE.
FERC proposes to incorporate different methodologies in ROE analysis
The most significant change detailed in the order is FERC’s proposal to incorporate several different cost-of-equity estimation methodologies into its ROE analysis. For more than two decades, FERC has relied almost exclusively on the discounted cash flow (DCF) methodology to estimate the equity cost of capital to be included in a utility’s cost-based transmission rates.
In its order, FERC proposed to employ several different methodologies in addition to the DCF. These other methodologies are: (1) the capital-asset pricing model (CAPM); (2) the risk premium methodology; and (3) expected earnings analysis.
In an appendix to the order, FERC provide an overview of DCF, as well as the three other methodologies.
FERC said that investors use CAPM analysis as a measure of the cost of equity relative to risk. “The CAPM methodology is based on the theory that the market-required rate of return for a security is equal to the risk-free rate, plus a risk premium associated with the specific security,” the Commission said.
The risk premium methodology, in which interest rates are also a direct input, is based on the idea that since investors in stocks take greater risk than investors in bonds, the former expect to earn a return on a stock investment that reflects a premium over and above the return they expect to earn on a bond investment, FERC noted.
“As the Commission found in Opinion No. 531, investors’ required risk premiums expand with low interest rates and shrink at higher interest rates. The link between interest rates and risk premiums provides a helpful indicator of how investors’ required rate of return have been impacted by the interest rate environment,” FERC went on to say. FERC’s Opinion No. 531, issued in 2014, was the order overturned by the D.C. Circuit in 2017.
Meanwhile, FERC said that because investors rely on expected earnings analyses to help estimate the opportunity cost of investing in a particular utility, “we find this type of analysis useful in determining a utility’s ROE.”
In explaining the decision to abandon its nearly-exclusive reliance on the DCF methodology, FERC cites investor reliance on other methods, as well as particular concerns with the DCF as historically applied by FERC.
FERC proposed a completely new framework for assessing whether a previously-approved ROE remains just and reasonable. Specifically, FERC would calculate a “composite” range of equity returns based on application of the DCF, CAPM and expected earnings methodologies to a representative proxy group of publicly-traded companies.
The Commission would then use the single composite range derived from the three methodologies “as an evidentiary tool to identify a range of presumptively just and reasonable ROEs for utilities with a similar risk profile to the targeted utility.”
FERC said that under the proposed framework, it intends to dismiss an ROE complaint if the targeted utility’s existing ROE falls within the range of presumptively just and reasonable ROEs for a utility of its risk profile, unless that presumption is sufficiently rebutted.
A revised approach to setting a new ROE
In addition, the Commission uses its order to put forward a fundamentally revised approach to setting a new ROE. FERC proposed to employ all four financial models to produce four separate cost of equity estimates. The four estimates would be averaged, effectively giving them all equal weight.
FERC said that the use of four different methodologies to calculate the ROE makes it unnecessary to assess whether current capital market conditions are anomalous, which is an issue that has been heavily litigated in the ISO-NE complaint proceedings.
FERC also explained that its current policy is to cap a utility’s total ROE, inclusive of any incentive adders, at the top of the zone of reasonableness. FERC clarified that its proposal is to use the composite zone of reasonableness produced by the DCF, CAPM, and expected earnings to establish the cap on a utility’s total ROE.
FERC applied its proposed framework to the record in the underlying proceeding to determine preliminary results.
Though the new methodologies generally produce ROE results that are higher than those produced by the DCF methodology, the overall revised framework would result in a slightly lower replacement ROE (10.41%) than FERC adopted in the Opinion No. 531 proceedings (10.57%).
In addition, FERC’s proposal to identify a presumptively just and reasonable range of ROEs in considering FPA section 206 complaints, instead of focusing on the single numerical result of a new DCF analysis – would likely make it more difficult to challenge existing ROEs. The order notes, however, that application of the revised methodology to the existing record would still buttress a finding that the base ROE of 11.14% challenged in the initial underlying complaint is unjust and unreasonable.
FERC did not formally adopt ROE methodology changes
FERC has not formally adopted the ROE methodology changes described in the order. Instead, FERC characterized the new framework as a proposal and established a paper hearing to address how the methodology should apply to the proceedings pending before the Commission involving the ISO-NE transmission owners’ ROE.
In its order, FERC directed participants in the proceeding to file briefs and additional evidence within 60 days of the order, with reply briefs due 30 days later.